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McKinsey Global Institute How Brazil Can Grow December 2006
McKinsey Global Institute
How Brazil Can Grow
December 2006
2
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How Brazil Can Grow
McKinsey Global Institute
December 2006
Rodrigo Couto
Heinz-Peter Elstrodt
Diana Farrell
Jorge Fergie
William Jones
Martha Laboissiere
Gianni Lanzillotti
Bruno Pietracci
Leonardo Ribeiro
4
Preface5
This publication is the result of extensive collaboration between the São Paulo
office of McKinsey & Company and the McKinsey Global Institute (MGI).
The project aspired to provide a fact base for the debate on how to increase
productivity and economic development in Brazil. Very specifically, our goal was
to identify, quantify, and rank the main barriers to productivity in the Brazilian
economy, as revealed by an analysis of representative sectors.
In addition to benefiting from a previous study on Brazilian productivity per-
formed in 1998, this work also draws on MGI’s in-depth productivity analyses
of more than 15 countries and over 30 sectors and research on global industry
restructuring and foreign direct investment in development countries. Extensive
input was provided by our external advisors, and over the course of this project,
we benefited from the unique, global outlook and deep industry-level knowledge
of McKinsey consultants in the sectors investigated in our case studies.
MGI Senior Fellow Martha Laboissiere and Bruno Pietracci, an Associate Princi-
pal in McKinsey’s São Paulo office, worked closely with us to provide leadership
to this project. The project team also included Rodrigo Couto, William Jones,
Gianni Lanzillotti, and Leonardo Ribeiro from McKinsey’s São Paulo office.
We would also like to acknowledge executives and experts who contributed their
industryand local market insights to this study. In the residential construction
sector we would like to thank Luiz Henrique Ceotto, Maria Angélica Covello,
Mário Kosmiskas, and Ubiraci Espinelli Lemes e Souza. In the agricultural sec-
tor, Cristine Handel, Eliseu Alves, Plínio Itamar de Melo e Souza and Elisio Con-
tini. To those who chose to remain anonymous, we also extend our gratitude.
As with all MGI research, this perspective is independent and has not been
commissioned or sponsored in any way by any business, government or other
institution.
Diana Farrell Heinz-Peter Elstrodt
Director, McKinsey Global Institute Mercosur Office Manager
August 2006
6
Brazil’s immense economic potential is undisputed. Expectations run high within
and beyond its borders that the country could be the next emerging economy,
after China and India, to see GDP growth take off.1 It has good universities,
a huge domestic market, and copious natural resources. Yet according to the
International Monetary Fund, Brazil’s GDP per capita has grown by an annual
average of only 1.5 percent over the past ten years. This is one of the lowest
growth figures of all the countries monitored by the Fund, and particularly low
for a developing nation (Exhibit 1).
Hyperinflation, the economy’s most pressing problem at the end of the past decade,
is no longer a specter. Brazil’s current fiscal and monetary policies have drawn praise
for their role in stabilizing the macroeconomic framework.2 Indeed some sectors of
the economy, particularly retail banking , telecom and export agriculture, are flour-
ishing. The problem is that these sectors employ only a tiny fraction of the workforce.
Most people are employed in sectors that have very low productivity growth,
particularly retail, residential construction and farming for the domestic market.
1 See Goldman Sachs Global Economics Paper 99 “Dreaming with BRICS: The Path to 2050”October 2003
2 See for example the OECD’s Economic Survey of Brazil 2005 at www.oecd.org
How Brazil Can Grow
2.3
1.1
2.0
3.7
2.6
4.1
1.5
1.9
7.6
4.1
31.6
Germany
Portugal
Korea
Chile
Russia
Brazil
25.7
15.0
15.5
8.5
6.9
7.2
US
India 2.1
Turkey
China
6.2
2.9
28.4
38.6
3.0
5.5
7.4
8.2
9.9
10.7
20.8
18.5
GDP/capita1995
Annual growth rate (CAGR)1995-2004
GDP/capita2004
23% 21%
48% 39%
BRAZILIAN ECONOMIC PERFORMANCE GDP per capita in US$ thousand at PPP; CAGR (%)
* GDP per capital in US$ at PPP 2003 prices.Source: International Monetary Fund - World Economic Database; team analysis
Exhibit 1
7
For the mass of Brazilians trying to make a living, life has not become noticeably
easier as inflation has subsided. Low GDP growth means their per capita incomes
are falling behind relative to those in other developing countries. In 1995 Brazil’s
per capita GDP was 46 percent of the Korean level: now it is only 39 percent.
McKinsey’s São Paulo office, in collaboration with the McKinsey Global Institute,
has examined Brazil’s economy to find out just how far its productivity is falling
behind, and what stops it from improving. The five main barriers we identified
look formidable: a very large informal economy, macroeconomic factors that
hinder investment, inappropriate regulations, poor public services and weak
infrastructure. The good news, however, is that all of them can be tackled
with the right policies. Indeed, other countries, such as Spain and Ireland,
have adjusted their economic policies to address similar problems and have
succeeded. Brazilians should take hope.
BRAZIL’S PRODUCTIVITY PROBLEM
Building on a previous analysis conducted in 19983 and similar MGI studies
undertaken in another 16 countries, we compared the performance of Brazil’s
economy with that of the United States in eight sectors—agriculture, automo-
tive, food retailing, government, home construction, retail banking, steel, and
telecommunications. Together, these sectors account for 37 percent of Brazil-
ian employment and 46 percent of the country’s GDP.
The new analysis makes clear that the chief culprit for Brazil’s underperform-
ance has been its failure to boost growth in labor productivity—the primary
determinant of a nation’s GDP per capita. Between 1995 and 2005, Brazil’s
productivity grew by only 0.3 per cent a year—compared with 2.8 percent
in the United States, 8.4 percent in China, and the 3.5 percent achieved by
neighboring Chile. Brazil’s labor productivity gap with the U.S. rose from 77 to
82 percentage points during this decade (Exhibit 2).
Our examination revealed that around one-third of the difference in productivity between
the United States and Brazil is due to structural factors inherent to Brazil’s position
in the economic development curve, and will work themselves out over time
3 See “Productivity: The Key to an Accelerated Development Path for Brazil”, McKinsey Global Institute, March 1998, at www. Mckinsey.com/mgi/ and Martin N. Baily et al, “Will Brazil Seize its Future”, The McKinsey Quarterly 1998, Number 3,
88
(Exhibit 3). The first of these is the fact that, because Brazil has a modest per capita
income, consumers generally can only afford lower-priced products and services (Exhibit
4). This effectively acts as a brake on Brazil’s development of home-grown higher value
added production; the country produces mostly smaller, low-priced cars, for instance, rely-
ing on imports for more expensive models (Exhibit 5). The second issue is that in Brazil
labor is cheap compared with capital, and this discourages the kind of capital investment
that would boost productivity (Exhibit 6 and 7). However, neither of these characteristics
need hold Brazilian productivity back in the longer-term, as long as the economy achieves
a healthier, sustained level of economic growth.
What matters most, however, are the non-structural hurdles that are responsible
for the remaining two-thirds of Brazil’s productivity gap. Our analysis has found five
primary barriers to raising productivity in Brazil: the large informal sector, macr-
oeconomic factors hampering investment, an onerous regulatory regime, and weak-
nesses in public service provision and the country’s infrastructure (Exhibit 8). These
barriers are distributed almost homogeneously across groups of industries (Exhibit
9). However, certain barriers have more pronounced effects in different sectors.
All of these could be tackled through adjustments to Brazil’s social and economic
policies. By far the most important of these, however, is the drag on productivity
exerted by Brazil’s informal sector (Exhibit 10).
2.82.7
1.0
0.7
3.3
3.5
1.2
1.7
3.1
0.38.4
1.7
BRAZILIAN LABOR PRODUCTIVITY PERFORMANCE GDP* /1,000 hour worked, CAGR (%)
Turkey
8.9Brazil2.3China
2.7India
38.9USA33.2France
32.8Germany
19.6Portugal
14.5South Korea
10.2Chile
12.2Mexico
10.3Russia
8.7
Labor productivity1995
Annual growth rate (CAGR)1995-2004
Labor productivity2004
49.942.2
36.0
20.9
19.4
13.9
13.5
11.9
11.4
9.24.8
3.1
23% 18%
* GDP in US$ at PPP 2003 prices.Source: International Monetary Fund - World Economic Database; Global Insight WMM 2005; IMD World
Competitiveness Year Book 2005, team analysis
Exhibit 2
9
10
Exhibit 3
28
13
118 5
65
100
11
35
BARRIERS TO PRODUCTIVITY GROWTH% of total gap
Source: Team analysis
Structural constraints that will naturally relax with Brazil's growth
produc-tivity gap
Structuralbarriers
Non-structuralbarriers
Infor-mality
Macro-economicinstability
Regu-lation
Public service provision
Infra-structure
Non-structural barriers
Exhibit 4
RELATIVE IMPORTANCE OF "STRUCTURAL" BARRIERSBY SECTOR
Source: Interviews; team analysis
Low impactModerate impactStrong impactNon-tradable
Capital intensive
Lowincomepercapita
Labor intensive
Size of themarket/Geogra-phics/ Demogra-phics
Lower historical cost of labor vs. capital
Retailbanking
Food retail
Less use of equipment
Residential constructionTelecom
PRELIMINARY
Public Sector
Tradable
Capital intensive
Steel
Lower processautomation
Auto OEMs
Lower processautomation
Auto parts
Lower processautomation
Lessuse of equipmentand pre-fabricated materials
Possibledue to automation of call centers
Lower penetration of bank services comparedto US
Lower expensesper capita
Lower quality of houses
Lower ARPU comparedto US
Lower purchasingpower of population
No strong evidence of impact of the size of the internal market, geographic or demographic differences over labor productivity of non-tradable sectors
N/A N/A N/A N/A
Agriculture
Loweruse of equipment
Exhibit 5
NUMBER OF MODELS PRODUCED PER GLOBAL AUTO SECTOR
Source: Global insight; team analysis
Asegment(mini)
Bsegment(compact)
Csegment(mid-size)
Dsegment (executive)
Esegment(luxury)
Bra
zil
0
0
1
1 1
1
1
0 1
1
1
1 0
1
0
0
0
0
0
0
US
0
0
0
0
0
0
0
0
1
4
1
1
2
2
1
1
2
7
2
0
Ford
GM
Honda
Toyota
Ford
GM
Honda
Toyota
AUTO SECTOREXAMPLE
Exhibit 6
CAPITAL INTENSITY AND USE OF EQUIPMENT
Source: Interviews; team analysis
Internalfinishing
Externalfinishing
Foundation/structure
Land work
Key activities
DemolitionGeneral excavation
Examples of equipment commonly used in the US
Truck loadersCompactorsPile drivers
Usage in Brazil
High
LowReasons forBrazil's gap
RESIDENTIAL CONSTRUCTIONEXAMPLE
Concrete fillingBrick layering Cranes
LiftersConcrete mixers
Small tools and electric equipment
Roof buildingFaçade finishing
Electric and hydraulicinstallationDoors and windows setting
Workers spend significant part of their time carrying weight between floors and across the construction siteOld technology/second-handequipment used"Man" power more frequently used than "mechanical" or "electrical" power
11
12
Exhibit 7
COMPARISON OF LABOR AND EQUIPMENTRELATIVE COSTS IN RESIDENTIAL CONSTRUCTION US$ per day
Use of equipment is driven by relative costs of equipment and laborCost of equipmentbased on financing rates for purchase of a 50m x 45m x 1t tower craneCost of labor based on unskilledlaborer
Assumptions
9
9
82
100
243
132
33
78
Worker wage in Brazil
Social costs
Wagedifference
Worker wage in US
Equipmentcost in Brazil
Cost of capital effect
Equipmentprice effect
Equipmentcost in US
Cost of labor Cost of equipment
9x
1.7x
Source: Interviews; team analysis
RESIDENTIAL CONSTRUCTIONEXAMPLE
Exhibit 8
NONSTRUCTURAL BARRIERS TO PRODUCTIVITY
RegulationExistence of limiting regulations that result in reduced sector productivity: labor regulations, price, product ,service regulations, land market regulations, regulatory complexity and bureaucracy, trade barriers, government ownership
Definition
InformalityEvasion of regulatory obligations that incur significant cost: tax obligations, labor market-related obligations, product-market related obligations
Macroeconomicfactors
Poor macroeconomic fundamentals manifested in high interest rates, volatile asset prices and atrophied credit and capital markets all with negative implications for investment
Infrastructure Deficient infrastructure capacity in key areas such as energy, roads, ports
Public service provision Inefficient provision of public services to the private sector
Source: Team analysis
12
13
Exhibit 9
IMPACT OF BARRIERS AT THE SECTOR LEVEL
Retailbanking Telecom Food retail
Residential construction Steel
AutoOEM
Autoparts
Capital intensive Labor intensive Capital intensive
Non-tradable Public AgricultureTradable
Regulation
Informality
Productivity gap driven by barriers to free competition
Productivity gap driven by barriers to leveling playing field
Productivity gap driven by barriers to international competitiveness
Productivity gap driven by dual economic model
Infra-structure
Public serviceprovision
Source: Team analysis
Macro-economic factors
Low impact
Moderate impact
Strong impact
Exhibit 10
RELATIVE IMPORTANCE OF EACH BARRIER
8
13
17
20
42
Impact on non-structural productivity gap
Source: Team analysis
100% = 65 points
17
Considers extrapolation to the whole economy based on sectors cases evaluated:
AgricultureAuto OEMAuto partsGovernmentRetailRetail BankingResidential ConstructionSteelTelecom
Regulation
Informality
Macroeconomicfactors
Infrastructure
Public service provision
BRAZIL’S INFORMAL ECONOMY IS THE BIGGEST OBSTACLE TO PRODUC-
TIVITY GROWTH
Brazil’s informal economy accounts for an estimated 40 percent of gross
national income, making it far larger than those in other emerging markets.
Having such a huge informal sector saddles Brazil’s economy with a set of com-
petitive and corporate distortions that profoundly compromise its prospects.4
Our analysis shows that it explains 42 percent of the country’s nonstructural
productivity gap with the United States.
By avoiding taxes, ignoring quality and safety regulations, or infringing copy-
rights, gray market players gain cost advantages that allow them to compete
successfully against more efficient, law-abiding businesses. Honest companies
lose market share, and thus make less money to invest in technology and
other productivity-enhancing measures. Less efficient players tend to have a
larger market share than they would have if they paid the taxes and labor fees
they are supposed to (Exhibit 11).
In the Brazilian retail industry, a good example of a sector blighted by the gray
economy, informal players enjoy higher margins than their formal competitors,
and small and medium-sized enterprises, less productive than larger firms,
derive an artificial advantage (Exhibit 12). In Brazil, small and medium-size
retail outlets have a dominant 79 percent share of the retail market compared
with 35 percent in the U.S. equivalent (Exhibit 13). The result is far lower
sales-per-employee (Exhibit 14).
More labor tends to be retained in unproductive activities than is economically
rational because it is artificially cheapened by tax and social security evasion.
In Brazil’s construction sector, for instance, the percentage of those working
in the informal economy increased from 66 percent in 1996 to 72 percent in
2003 (Exhibit 15). Informality also discourages investment in automation and
up-to-date equipment. There is no incentive for small, informal businesses
to reach the scale required to innovate and adopt best practices because
growing bigger increases the risk that the authorities will detect their informal
practices.
4 See Diana Farrell, “The hidden dangers of the informal economy”, The McKinsey Quarterly, 2004, Number 3
14
15
Exhibit 11
IMPACT OF INFORMALITY THAT HINDERS PRODUCTIVITY
Description Evidence foundType of distortion
Example of sector
Tax related
Evasion of VAT and income tax through under reporting of sales and use of informal suppliers
Evasion of VAT and social security obligations allow informal food retailers to enjoy additional return on sales
Food retail
Evasion of social security obligations and minimum wage payments by not reporting all employment or full employment working hours
Evasion of social security obligations and VAT allow informal construction companies to enjoy cost advantage
Labormarket related
ResidentialConstruction
ResidentialConstruction
Evasion of minimum product quality requirements, property rights and security/ environment standards that would increase the costs of goods or services
Avoidance of security norms may induce additional cost advantage to informal players
Productmarket related
Source: Team analysis
Exhibit 12
nformal sector assumption is that 30% net sales and employee costs go unreported.
national Company Investment in Developing Countries, 2003
ADVANTAGES OF OPERATING INFORMALLY IN RETAIL ARE EXTREMELY HIGH IN BRAZILIndexed to formal sector net margin = 100
40
55
345
100
150
Formalplayer net income
VAT and specialtaxesevasion
Social security paymentevasion
Income tax evasion
Informalplayer net income
Key advantage for informal retailers in Brazil
16
Exhibit 13
6
94
Total*
PRODUCTIVITY IS SIGNIFICANTLY AFFECTED BY THE MIX BETWEEN LARGE AND MEDIUM/SMALL FORMATS IN RETAILIndexed to same segment in US 2001 = 100
100
US
16
Brazil
Large
Medium/small
100
US
68
Brazil
100
US
18
Brazil
* Average productivity is lower than that of both segments because the less productive medium/small segment has higher employment share in Brazil than in the US.
Employmentshare%
21
79
Market share%
Exhibit 14
COMPARISON OF SALES PER EMPLOYEE IN MEDIUM/SMALL FORMATS IN RETAIL
Sales per employee
US
43
192
Productivity
US
3
19
Main drivers
78% 82%
FURTHER BARRIERS TO HIGHER PRODUCTIVITY
While tackling the gray economy should be Brazil’s first priority, four further
hurdles to higher productivity also deserve policymakers’ close attention.
Macroeconomic factors
Despite significant improvements, Brazilian business still suffers from uncer-
tainty regarding the sustainability of (relative) economic stability (Exhibit 16).
Brazil’s interest rates are among the highest in the world, its governments
debt remains below investment grade and long-term financing is virtually
non-existent. These conditions reduce the willingness and raise the costs of
investments to businesses, and discourage long term-investment. The distor-
tions brought on by macro instability are seen throughout the economy. For
example, sectors such as residential construction, which relies on long-term
consumer credit, are hampered by the embryonic nature of Brazil’s capital
markets and therefore the limitations on mortgage finance. In agriculture, the
limited mechanization observed may be explained by the high relative cost of
agricultural equipment—due largely to the higher cost of capital (see exhibit 7).
17
EVOLUTION OF INFORMAL EMPLOYMENT IN RESIDENTIAL CONSTRUCTION
* Employers, unpaid workers, workers in construction for own use and public servants.Source: PNAD; team analysis
Overall construction labor forcethousand employees, %
78
2126
26
40
4,205
1996
26
46
5,130
2003
100% =Employees with working card
Mostly informal
Formal
Other*
Employees without working card
Self-employed
Exhibit 15
18
McKinsey estimates that macroeconomic uncertainty accounts for 20 percent
of the productivity deficit produced by the five primary barriers.
Regulatory constraints
Brazil’s complex, bureaucratic regulatory regime accounts for another 17 percent
of the nonstructural productivity gap, according to our estimates. Our definition of
regulations covers the gamut from labor and tax laws, to price controls, product
regulations, trade barriers, and subsidies (Exhibit 17). Regulatory constraints on
productivity are particularly marked in non-tradable, capital-intensive sectors such
as retail banking and telecoms.
Labor laws. Brazil’s labor legislation is rigid, particularly in comparison with
the United States, and this significantly constrains productivity. The thorniest
problem for businesses is limits on hiring and firing workers. This leaves them
vulnerable to fluctuations in demand, particularly in highly cyclical sectors such
as residential construction. The high cost of laying off workers encourages
informal employment. All too many employers find this route attractive because
MACRO ECONOMIC FACTORS THAT HINDER PRODUCTIVITY
DescriptionType of distortion
Residentialconstruction
Auto OEM
Impact of high interest rate on consumers of goods produced by sector
Unavailability of long-term capital results in underdeveloped mortgage market
High interest rate depresses auto loans. Most OEM are forced to provide subsidized financing to increase sales
Cost of
financing
Auto OEMExchange rate fluctuations impact company planning
Planning for export is dependent on exchange rates. Automation/ expansion investments delayed/cancelled
Exchange ratevolatility
Auto OEM
Agriculture
Impact of high interest rate on suppliers
High return required on investment on factories and production lines
High capital cost of agricultural equipment which limits mechanization
Cost of
investment
Source: Team analysis
Sector Evidence found
Exhibit 16
it allows them to avoid paying expensive payroll taxes, and gives them the flex-
ibility—not available in the formal sector—to manage their work forces. Labor
market rigidity, which affects all the industries we studied, is clearly hampering
the ability of Brazilian companies to optimize their operations and create new
jobs, and deters foreign direct investment in Brazil.
Tax regulation. High taxes drive costs up and demand down. For instance, the
actual cost of making similar vehicles in the United States and Brazil is about
the same; but add in Brazil’s sales taxes, and prices rise significantly across
the entire Brazilian manufacturing chain to the detriment of the final consumer
(Exhibit 18). High prices not only reduce overall demand for new vehicles, but
also the average value of automobiles sold in Brazil.
Regulatory complexity and bureaucracy. Brazil labors under a web of city, state,
and federal taxes and regulations that hinder entrepreneurialism and make it
difficult for the financial system to function. In the residential construction sec-
tor, standards are imposed that are prescriptive and not performance-based.
For instance, they will stipulate how thick a wall must be, but say nothing
about the structural resistance or thermal and acoustic insulation it should
19
REGULATIONS THAT HINDER PRODUCTIVITY
SectorDescription Evidence foundType of distortion
Retail bankingRegulation that allows government ownership of players
Three government owned banks hold 40% of employment and 35% of assets and have half as productive as private sector banks
Government ownership
Auto
Residential construction
Restrictive labor laws regarding retaining policies
Rigid labor agreements increase employment levelsLow flexibility to adjust capacity to demand
Laborregulations
Residential constructionAll sectors
Legal requirements and completion times for business processes
Smaller share of large scale construction
Excessive bureaucracy results in high time investments for companies
Regulatory complexity and bureaucracy
Retail bankingTelecom
Regulation restraining free development of players value proposition
Restrictive occupation descriptionForces investments where they are not necessarily the best business choice
Price, product, serviceregulation
AgricultureAuto
Government subsidies/ international trade barriers
Disadvantage for Brazilian players vis-à-vis US subsidiesState Government subsidies are linked with job creation and maintenance
Trade barriers/ subsidies
TelecomAll sectors
High taxation Taxes applied are highest worldwideTaxes over salaries makes labor more expensive (favors informality)
Tax regulations
Source: Team analysis
Exhibit 17
20
provide. These imposed standards tend to delay the incorporation of innovative
construction with superior properties. For example, drywall, widely used in the
United States, has very low penetration in Brazil.
Price, product, service regulation. Certain regulations limit the proper function-
ing of a free market, raise obstacles for the entry of new players, set artificial
price levels, or introduce standards and requirements that impede optimum
operations or trade. For instance, the cost efficiency of Brazil’s commercial
banking sector—measured as a cost-to-income ratio—improved between 1997
and 2002, dropping from 80.1 to 70.8. But the ratio among US banks fell from
60 to 55 over the same period, leaving Brazil’s banks still far behind (Exhibit
19). This difference is attributed to legislation relating to financial products,
formats of service provision (e.g., hours of service), and other sectorial regula-
tions in combination with labor and tax regulations.
Subsidies and barriers to free trade. Productivity is compromised by a panoply
of regulations that hamper free trade, including prohibition on the entry of
new competitors into a particular market, tariff protections, and subsidies that
favor some players over others.
SALES-TAX FREE PRICES* OF SIMILAR CARS INBRAZIL AND IN THE US
Sales tax-free prices* for identical vehicles in Brazil are similar; however taxation in Brazil is higher(~30% against ~7%in the US) resultingin higher prices to consumer
This effect drives both demand and value-added per vehicle down
* This is a consumer price comparison only. There are still value-added taxes distributed across the supply chain , which are bigger in Brazil than in US.
Source: FIPE; IPE; Global Insight; McK research; team analysis
13.2 13.2 12.1 11.113.9 12.7
Toyota GM Honda
18.8
14.2
18.6
12.0
19.8
13.7
US$ thousand, 2004
AUTO SECTOREXAMPLE
USA
Brazil
Respective sales taxes
Exhibit 18
21
State-owned businesses. Government-owned businesses overall have lower
productivity than companies in the private sector. In the retail banking sector,
for instance, state-controlled banks own 37 percent of all the assets of the
banking system and account for 40 percent of its employment (Exhibit 20).
This drags down the productivity of the sector as a whole. The productivity
of Brazil’s publicly-owned banks is only just over half of the country’s leading
private bank (Exhibit 21).
Public sector weaknesses
Inefficient public services account, we estimate, for up to 11 percent of the
primary barriers to Brazilian productivity growth that we identified. Public serv-
ices are responsible for 11 percent of total employment in the country (Exhibit
22). They do not deliver effectively, and that holds the private sector back.
For instance, one-quarter of the population receives no secondary schooling;
almost 12 percent of adults—some 15 million people—cannot read or write.
This impedes the adoption and use of innovative new products and techniques
in sectors such as agriculture.
* Based on sample of 164 banks. Source: Bankscope
THE COST EFFICIENCY OF BRAZILIAN BANKS
80.1 80.1 78.587.2
77.770.8
1997 1998 1999 2000 2001 2002
USbanks 59.1 61.0 58.7 58.5 57.6 54.9
-2.4%
CAGR
Cost-to-income ratio of commercial banking sector*%
RETAIL BANKINGEXAMPLE
Exhibit 19
22
Exhibit 20
GROWTH OF MID SEGMENT OF BRAZILIAN BANKS
* Bradesco, Itaú, Unibanco.Source: Austin Asis; Brazilian Central Bank; Febraban; team analysis
Share of assets Share of employment
RETAIL BANKINGEXAMPLE%
30
35
1325
1
56
577
1994
3
37
1,129
2002
100% = R$
MixedPrivateforeignPrivatenational
State-owned
21 37
27
7
16
2
50
571
1994
40
389
2002
100% = R$
Others
Foreign privateTop 3national private*
State owned
Exhibit 21
Sectoraverage = 67
RELATIVE PRODUCTIVITY OF PRIVATE AND PUBLICBRAZILIAN BANKS
* Ranking based on share of assets.Source: Austin Asis; team analysis
101
Leadingforeign private
100
80
Top 3national private*
71
Top 3foreign private*
41
Top 3governm.Owned**
Public banks with lowest productivity
36
US
Indexed, US = 100
RETAIL BANKINGEXAMPLE
23
Infrastructural weaknesses
Finally, Brazil has a significant infrastructure deficit with inadequate highways,
ports, railroads, and power generation and storage facilities (Exhibit 23). McKin-
sey estimates that this accounts for 5 percent of the primary barriers to greater
productivity. In agriculture, for instance, up to 12 percent of rice produced in
Brazil spoils before reaching ports or the end consumer (Exibit 24). Freight costs
and port tariffs for Brazil’s soybean producers are $16 a ton or 55 percent
higher than the equivalent costs for their US competitors, reducing their margins
on international prices by 10 percent (Exhibit 25). Costs in Brazil’s automotive
industry are raised by factors including relatively expensive transportation and
long waiting times at dockside, which cause expensive build-ups of inventory.
THE WAY FORWARD
The barriers to improving productivity in Brazil’s economy are formidably deep-
seated. Dismantling them is bound to be hard work. But there is much cause
for optimism. In our experience, once the sources of low productivity are identi-
fied, there is no impediment to governments adopting a program of long-term
structural and economic adjustment.
PUBLIC SERVICE DISTORTIONS THAT HINDER PRODUCTIVITY
Source: Team analysis
Service provided by government is subpart for populations needs
High illiteracy ratesInfant mortality
EducationHealth
Inefficiency in public sectorserviceprovision
Low public investment
Inappropriateinvestment in necessaryinfrastructure
Low investment in necessary infrastructure results in high transportation costs, delays and product losses
Agriculture
Highgovernment spending
High government spending increases interest rates
Hampers consumer borrowing and investment by firms
All capital intensive and consumer finance dependent (e.g., residential construction, auto)
SectorDescription Evidence foundType of distortion
Exhibit 22
24
Exhibit 23
INFRASTRUCTURE DEFICIENCIES THAT HINDER PRODUCTIVITY
Description Evidence foundType of distortion
Source: Team analysis
Sector
Poor port infrastructure that results in higher export costs
Port tariffs for soybeans shipments are twice as high as in the USPorts
SteelAgricultureAuto
Poor road infrastructure causing delays and increasing transportation costs
83% of roads in Brazil are in bad conditionHigh freight costs and high product losses in transportation
RoadsAll sectors
EnergyRisk of shortage Energy shortages that occurred in
2002 and are forecasted to happen again in the next 5-10 years
All sectors, especially capital intensive
Storage capability High product losses due to lack of storage and poor storage conditionsReduced producer bargaining power due to lack of storage capabilities
StorageAgriculture
AgricultureUnderdeveloped rail and boat transportation
High usage of high cost road transportation relative to rail and boat transportation
Othermodes of transportation
Exhibit 24
% of production, 2003
Source: IBGE; team analysis
3.0
8.0
12.0
8.5
7.0
BeansWheatRiceCornSoybeans
AGRICULTUREEXAMPLE
25
Take the informality barrier. The government of Brazil has started to undertake
key structural reforms that will tackle this problem—passing public pension and
tax bills and legislation to modernizing bankruptcy law. Predominantly informal
sectors—such as retailing and construction—will require even more tailored,
structural changes. By tackling informality sector by sector, and tailoring the ap-
proach, policymakers will be able to deliver the kind of quick wins that generate
the political momentum required for further change. For instance, the federal
tax collection agency now requires leak-measurement devices in all Brazilian
beverage plants—a move that could quickly cut by some 70 percent the sector’s
estimated annual tax evasion of 720 million reais, or $360 million.
Brazil also needs to tighten up its legal system, and consider following the lead
of other countries such as Ireland and the Netherlands in creating a special
agency to fight evasion of taxes and social charges. More fundamentally, it
should consider lowering the burden of both taxation and regulation—so that
informality doesn’t pay.
Such measures, along with policies to tackle Brazil’s other major productivity
barriers, have succeeded elsewhere. The government of the Republic of Ireland,
US$/t/1,000 Km*
* Average distance from farms to ports is approximately 1,000 km for both Brazil and US.** Soybeans prices in the Chicago board of trade fluctuated between US$ 168.8 and US$ 277.8/t in the last 10
years.Source: Veja; CBOT; team analysis
Freight costs and port tariffs are US$ 16/t
the US
freight and port tariffs
10% of prices received 15
283
6
Freight to port
Port tariffs
Brazil US
18
34
AGRICULTUREEXAMPLE
55%
Exhibit 25
26
for instance, transformed the country’s economic prospects and performance
within a relatively short time-scale by embracing a well-articulated strategy to
dismantle the kind of barriers we have found in Brazil.
Two-thirds of Brazil’s productivity deficit can be tackled by changes in govern-
ment policy. The rest will come when the economy moves onto a sustainable,
healthy growth track. There is all to play for.
27
THE ROLE OF EDUCATION AND INNOVATION
Our research indicates that a combination of investments in training and
evolution in production processes can result in significantly higher pro-
ductivity in Brazil with the currently available labor pool, in spite of its low
educational level. This conclusion is consistent with that reached in other
countries studied by MGI. Therefore, we have not identified education as
one of the key barriers to Brazilian economic growth.
This conclusion should not be interpreted as a suggestion that we do not
believe education is important. We are aware of the empirical evidence in
Brazil and abroad, indicating that investment in education can contribute to
increasing output and improvements in the distribution of income, and that
in almost all countries that reached a high per capita GDP, the labor force
had more schooling than in Brazil. We also recognize the role of education
in strengthening civil society.
Our conclusion implies that Brazil need not wait for a new generation of
more highly educated workers to join the labor force before it can achieve
rapid productivity growth rates and significantly higher GDP per capita lev-
els. It also implies that the full potential of the Brazilian worker will remain
unrealized if policy makers do not address the barriers limiting Brazil’s near
term growth prospects.
27
THE ROLE OF EXCHANGE AND INTEREST RATES
Relatively “high” interest rates and a “low” (“overvalued”) exchange rate
are frequently cited in Brazil’s economic debate as key barriers to faster
growth. Neither, however, is listed among the barriers we identify.
Regarding exchange rates, our research approach focuses on understanding
differences in productivity levels of all the workers in an economy. The
proportion of workers in “tradeable sectors”, where a devaluation would
presumably have the strongest direct effect, is typically relatively small.
Further, an “overvalued” exchange rate favors the importation of capital
inputs and increases the competitiveness of foreign goods and services,
both of which are factors that tend to favor productivity growth. Reflecting
this apparently ambiguity, despite the compelling “anecdotal evidence (e.g.
China, Korea, …), our interpretation of the empirical evidence is that there
is no clearly established link between FX rate levels and GPD growth rates.
Clearly, an FX rate policy that deteriorates the country’s external accounts
and exposes it to significant external shocks is undesirable. However the
very large positive trade balance and the recent current account surpluses
suggest this is not the case in Brazil.
With respect to interest rates, we do believe that interest rate levels among
the highest in the world adversely affect investment capacity and therefore
Brazil’s growth prospects. However, we also believe these interest rates are
primarily a consequence of economic policy and a measure of the perceived
soundness of its economic fundamentals. Direct (or “unilateral”) efforts
to reduce interest rates will almost certainly prove counterproductive.
Measures that remove the anomalies around Brazil’s fiscal condition
(e.g. excessively high level of spending and taxation, excessively high
public sector consumption) are what is needed to bring about sustained
reduction in interest rates. Such measures will contribute to an increase
in the overall level of investment in the economy, both because of impact
on risk perception but also because they will restore the public sector’s
investment capacity.
28
29
Methodology
The methodology employed was developed by the MGI and has been used
in more than sixteen developed and developing economies. It combines
detailed analyses of labor productivity in different industries with a set of
transverse analyses of the economy as a whole.
For this study we analyzed six sectors: agriculture, automotive (OEMs and auto
parts), residential construction, government, food retail, and retail banking.
The steel and telecom industries were also taken into account. These
sectors were selected based on the criteria of providing significant coverage
of different areas of the economy, including nontradable capital intensive
(banks and telecom) and labor intensive (food retail and construction)
sectors, tradable capital intensive (steel, automotive) and labor intensive
(agriculture) sectors, as well as the public sector (government). Combined,
these sectors are responsible for 37 percent of employment in Brazil and 46
percent of its gross domestic product (GDP).
There were three parts to this methodology:
We first calculated the financial productivity (and the gap compared to the
United States) for different industries. This analysis was based on the
value added and employment in each sector according to data published by
the Brazilian Institute of Geography and Statistics (IBGE) and the National
Research on Households (PNAD). For industries where IBGE or PNAD data
could result in distortions, quantitative checks were made against the
physical output of the sector. For example, in the automotive sector, data on
the actual number of vehicles produced was used in addition to government-
supplied data.
We subsequently mapped the operational causes that explained the
differences observed between Brazil and the United States—factors such
as differences in manufacturing processes, levels of automation, capacity
utilization, and so on. These causes, said to be the root causes, were identified
during the course of extensive interviews and were quantified based on
sector markers.
Finally, we mapped the difference in productivity along each root cause against
factors that impede parity with the United States. These factors are defined
as the non-structural barriers, which can be grouped into informality, regulation,
macroeconomic factors, infrastructure, and public service provisions. Although
these groups can be isolated and analyzed, they are neither independent
nor mutually exclusive. Throughout the course of this study we will point out
the interdependencies between these barriers and demonstrate how one
may feed into another.
30
31
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